Why is this important? Lots of people think hyperinflation is right around the corner. These people are wrong.

Not wrong in the sense of a “valid counter argument” wrong, but rather, they are wrong in the “not understanding the logic flow of the operating system” wrong. They are wrong like the guys in business suits telling the programmers the program will crash the computer because “the program is too fast, so slow it down” wrong. They don’t understand the basics of how computers work, so the problems identified and solutions proposed seem hilarious to people who really understand the nuts and bolts of programming.

Unfortunately, the real world consequences of these misunderstandings are gigantic. We are all at least 5% poorer than we should be because of these huge errors.

Cullen has pounded the table on the exact topic of reserves for several years, so it’s nice to have some mainstream recognition of the basic facts of how our monetary system works. It’s remarkable, but this paper reads as though Cullen Roche and JKH were the ghost writers.

Additionally, he name checks MMT, Godley, Lavioe, and Wray in footnote 4.

Really, looking at this more closely, it seems like he might be reading Monetary Realism.

Look at the table of Contents:

Table Of Contents
The Money Multiplier View Of Credit Creation
What Determines The Level Of Central Bank Reserves
How Banks Create Loans
Where Deposits Come From
Interest-Rate-Targeting Central Banks Supply Whatever Reserves Are
Needed
How Things Change Under QE
Why Understanding The Balance-Sheet Mechanics Of QE Is Important
The Bottom Line
Endnotes
Related Research

“Another way to conceptualize QE is as a debt management operation of the consolidated government (the government plus the central bank). When a central bank does QE by buying long-term government debt or government-guaranteed assets, the consolidated government retires long-term debt or guarantees on long-term debt and issues central bank debt (reserves) instead. This shortens the duration and debt servicing costs of the consolidated government’s outstanding debt, particularly when the central bank does not pay interest on excess reserves. This debt management operation effect is the flip side of the portfolio rebalance effect visited on the private sector’s aggregate portfolio”

Also, for some reason, the chief economist of S&P felt compelled to dispel the money multiplier myth, because so many people think there is a money multiplier. He does us a favor by collecting a large number of quotes from influential economists who apparently believe in the money multiplier view of credit creation. Noah Smith, read footnote 2 and weep with us. This view is everywhere.

(Update: I’ve had time to read Paul’s note more carefully. This note will become the primer on understanding banking reserves and how they impact credit creation. Paul’s note on the Platinum Coin is also excellent. His understanding of the system is very deep. )

Paul Sheard is actually using the MMT framework in this paper even if he gets the endogenous money stuff right. I think there’s a quote in there about the govt “destroying” bank deposits or something like that. He’s not getting his stuff from MR or even Lavoie. He’s getting it from Mosler, etc. Which is better than getting it from Paul Krugman, I guess.

Not bad from S&P. A few suggestions for the author, just in case he sees your post, Mike: The fact that banks don’t lend reserves and don’t need reserves to lend, etc. is important, but the way in which banks actually do make lending decisions is the positive complement to that observation. The explanation of that is actually far more complicated than the correct explanation of how the bank reserve system works. The blogosphere and mainstream economics has that to look forward to. Detailed capital and risk management criteria are central to that. That said, if mainstreamers such as those people included in the footnote are still ignorant of how the reserve system works, I can’t imagine how long it will take for them to wake up to how capital and risk management work in informing actual bank lending decisions. Next, those who do understand reserve operations and the basics of loans creating deposits do sometimes get carried away in the process. It needs to be emphasized that this all relates to the idea of original deposit creation. It does not relate to real world bank funding, where banks actively manage their deposit portfolios and do need to attract deposits in the context of maintaining a balance sheet that already has loans in place. That’s because deposits, once created, can be fickle with respect to which bank they will stay with, until they are destroyed. But I guess once again, like the relationship between reserve management and capital management, we have to walk before we run. Anyway, that was the objective in my writing this post (which you already linked to Mike, thanks): http://monetaryrealism.com/loans-create-deposits-in-context/ Finally, the S&P paper might have referred a little more to the importance of paying interest on reserves as a tool for potential monetary tightening. The… Read more »

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A H

3 years 3 months ago

I’m still not really sure what to think about QE exit and higher IOR. Here are some rambling thoughts on the matter. Some details are definitely wrong. Pre-financial crisis the Fed created an destroyed reserves in order to target some inter-bank interest rate, creating reserves by buying bonds to push down the rate and destroying reserves by selling bonds to push down the rate. So the amount of reserves was basically endogenous to money market conditions and the interest rate the fed is targeting. But still, only the Fed can create and destroy CB reserves, right? This changes after the financial crisis, because of the zero lower bound on interest rates. So then the fed targets the quantity of reserves instead of interest rates, hence Q.E. So part of my confusion is that after QE, what happened to the relation between reserves and interest rates. In “normal” times interest rates determine reserves, but after QE it seems that this relationship has broken down, but is this really true? If the Fed wanted to tighten and started selling bonds and destroying reserves, I think that we would quickly see rising interest rates, and I think very few people would take the other side of the bet. So why even bother to use a higher IOR in the first place? However this is a bit confusing, because theoretically, there should be some relation to the stock of bonds and reserves that sets the interest rate the fed is targeting, and QE should have put this relationship out of wack, so that the fed has to sell a certain amount of bonds before there is an effect on the interest rate. But I doubt that this would be true in reality, and even if the fed needs to sell a lot of bonds… Read more »

It’s useful to distinguish between long interest rates and short interest rates; the yield on long-dated Treasuries and the Fed Funds rate.

Both pre and post QE, the Fed can and does set the Fed Funds rate. QE doesn’t change that. However, QE enables the Fed to exert an additional influence over long rates. By buying longer dated Treasuries, the Fed reduces the supply of Treasuries in the market, pushing up the price and reducing the yield. This is quite independent of what it does with the Fed funds rate. The increase in reserves is just the counterpart to the reduction in Treasuries and is in many ways the least interesting bit of what is going on.

There is a further distinction to be made where the Fed buys private securities rather than Treasuries

And you used it well in your posts on QE on this as this point is important in the analysis.

Interesting PKE history here which you will probably know:

It was Kaldor who promoted the idea of expectations for long term yields and wrote as if it is the only thing that matters. There is a nice essay by Joan Robinson in the 1950s where she takes him to task on this – although I don’t think Kaldor came back with any reply. Even though there is some logic to the expectations theory, people write in a manner implicitly assuming the future is already known and I frequently think of how to write about it but Robinson’s words are the best I think. I will probably write a post just quoting her sometime.

I think it’s good to separate out the different types of QE. “Twist” type QE of buying long maturity treasuries and the fed buying private securities are important, but what I was talk about above is about “pure” QE, which is the Fed buying short treasuries in essentially the same way as it does in open market operations, except with a quantity target. It’s not clear to me what the effects of “pure” QE are on the feds impact on interest rates.

I find it hard to see what purchasing short-dated Treasuries for reserves would achieve beyond the normal control of the Fed funds rate. However, I’m afraid my main familiarity is with the UK, rather than the US, so maybe there’s something I’m unaware of in the way monetary policy is conducted there. In the UK, it would make little impact as bills can be easily used to obtain central bank reserves anyway.

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A H

3 years 3 months ago

Well it’s supposed to work through a portfolio balance effect which makes sense to me. The money used in QE has to end up as deposits somewhere, especially since most treasuries bought in QE were not held by banks originally.

My question is that if QE does have effects on the economy, then why is there talk about unconventional policies like raising IOR at all. To tighten all the fed has to do is unwind QE to the appropriate level. If it doesn’t have any effects, then unwinding it or not won’t matter.

Seems that Cullen has a post up on this too. He will probably see that at least.

Also, he’s been on this for a while. He’s written an article about the Platinum coin which is spot on too, back in January. Paul gets it.

It’s tough with papers like this – he’s probably torn between getting completely wonky on one hand, but also make the case simply enough any economist can understand. The more detail added can become counter productive if he’s just making the case in a research note.

I’ll have to read through the Coin piece carefully, but the first paragraphs are very encouraging.

” It does not relate to real world bank funding, where banks actively manage their deposit portfolios and do need to attract deposits in the context of maintaining a balance sheet that already has loans in place. That’s because deposits, once created, can be fickle with respect to which bank they will stay with, until they are destroyed”

This is a good point – individual banks “need” deposits in a way, but the “need” for this is entirely different than the money multiplier story “need” for deposits to create loans.

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JKH

3 years 3 months ago

Oh, I think its a pretty good piece. Was just offering a few suggestions in context.

You’re right that the economics profession has currently got very little to say on how bank lending volumes and pricing are really determined. I’ve yet to see any kind of model that really rings true. Godley and Lavoie make a valiant stab at it, but I don’t think it really stacks up. It looks to me like they have taken Godley’s ideas about how industrial pricing works and tried to fit it to a bank model.

Unfortunately though, I don’t think that it is ever going to be something that can be set out in a neat little conceptual form. For example, capital is a crucial element in bank lending and, in my view, it is impossible to understand what happened to the loan market before and after the crisis, without understanding how capital constraints shaped behaviour. But that whole relationship is intimately tied up in the development of capital sparing techniques (principally ABS and CDS) which just doesn’t lend itself to neat models.

That’s not to say the profession can’t get to understand banking better – just that they might have to accept that models may be of limited use.

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A H

3 years 3 months ago

This is all in Minsky. “Stabilizing an Unstable Economy” is an incredible and still underrated book. Most people only know the simplified version of his hedge – speculative – ponzi finance scheme. But the way he lays out the working of the financial system and how financial commitments over time are the key driver of modern capitalism is the best description of how the economy works that I have read.

Godley and Minsky are a great PKE tandem. They share the same basic economic framework, but come at problems from a different angle and really complement each others weaknesses.

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JKH

3 years 3 months ago

“But that whole relationship is intimately tied up in the development of capital sparing techniques (principally ABS and CDS) which just doesn’t lend itself to neat models.”

Actually, banks are very precise in the way they model this – the model is embedded in the form of risk calculation mathematics, which is then used in capital allocation breakeven costs. One of the sources of the financial crisis, boiling it down in ultra-simple terms, was that they were plugging the wrong standard deviations (in effect) into the risk models. That’s partly because of physicists, who knew even less than economists about banking, being employed by aggressive trading desks, and those same trading desks getting out of control under the wrong corporate culture. That’s a problem. And its only one problem. (AIG combined that with total lack of regulatory scrutiny) But that’s a peripheral problem than can be solved relatively easily by comparison to the fundamental dilemma of an economics profession interfacing ineffectively with banking with respect to analysis that matters. But yeah, models are of limited use anyway in banking as well as economics. The best banks, the ones that survived the crisis, used models as just one input to judgement – not drivers of judgement.

And, of course, these sorts of models are subject to a particular problem reminiscent of the Lucas critique. The models are developed based on observation of what has been done before, but once implemented, they simply create a framework which can be arbitraged. Bankers will always look for ways to arbitrage – it’s in their nature, it’s what they are paid to do. And one of the richest sources of arbitrage is the capital framework. There are several clear instances of this happening in the run up to the crisis, such as the way that banks exploited the structured finance models of the rating agencies, and (as I’ve written about in http://monetaryreflections.blogspot.co.uk/2013/06/bank-capital-and-derivatives.html) the banking book / trading book distinction.

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JKH

3 years 3 months ago

Agree with that in general. I think traders will look to arbitrage where possible – not so sure about bankers in general. There is an adult/child distinction in the more prudent cultures – but there aren’t enough prudent cultures with good qualified judgment on risk taking flowing down from the top of the house. Dimon failed big time in the whale case there – over-delegation. Yes the risk math can be exploited. But that’s partly what I mean by judgment in the internal supervision of risk taking, particularly in setting limits and deciding what trading businesses to get into. Most of the measured outright credit risk is still usually in the banking book and measured trading book market/credit risk and capital allocation is usually small relative to credit risk in total. Hedge effectiveness rules also made it more challenging for banking book risk taking.

What’s the relationship between the Lucas critique and ergodicity as it might apply here – if any?

I don’t think I understand ergodicity enough to answer that question. I was just thinking of the way that bankers (traders?) respond to changes in the regulatory structure so that it never actually works as intended, and it reminded me of the Lucas critique. I was involved at one point in looking at how to incorporate capital weightings for structural risk in structured finance transactions and I concluded it was impossible, because everything you could think of would just mean the structurers would do it differently. The thing being modeled is not independent of the regulatory model itself.

An interesting point you make about most measured credit risk being on the banking book. That is true, but it doesn’t necessarily reflect the full position partly because exposure to the underlying is treated as market risk in the trading book and the only measured credit risk is to the counterparty, which is often covered by collateral. As I mentioned in my post, the vast majority of bank losses in the crisis were in some form of traded credit (including positions which were transferred to the banking book when they became illiquid).

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JKH

3 years 3 months ago

quite right

I think of the AIG financial products problem as being a combination of the “wrong standard deviations” (simplified as above), plus poor internal supervision over risk limits, plus reckless regulatory ineffectiveness when it comes to non-banks especially. So losses exploded way over measured risk in the trading book.